Auditors

All CPA firms have to be registered with the U.S. Public Company Accounting Oversight Board (PCAOB) if they want to audit U.S. public companies, including U.S.-listed Chinese companies:

"Public companies, whether located in the United States or abroad, access U.S. capital markets by complying with certain U.S. legal requirements, including the requirement to periodically file audited financial statements with the U.S. Securities and Exchange Commission. Under the Sarbanes-Oxley Act of 2002, the auditor of those financial statements - whether a U.S. auditor or a non-U.S. auditor - must be registered with the PCAOB, and the PCAOB must regularly inspect the firm to assess its compliance with U.S. law and professional standards in connection with those audits." (PCAOB)

In light of the length of time that has elapsed without successful resolution of the obstacles, and the continuing inability of the Board to inspect PCAOB-registered firms in some jurisdictions, the Board has re-evaluated its approach to new registration applications from firms in those jurisdictions. The Board has determined that its consideration of new applications from firms in those jurisdictions will no longer be premised on an expectation that those obstacles will be resolved without undue delay to any necessary PCAOB inspection of a firm. (PCAOB)

China has prohibited the PCAOB from inspecting its CPA firms, including the Hong Kong firms if the inspection would include mainland Chinese clients. This includes all Chinese accounting firms, including the Chinese or Hong Kong member firms of the Big 4. But China is not alone with this policy, as most European countries block the PCAOB on similar grounds (national sovereignty, legal matters). Let's have a look at Europe's largest economy, Germany, and the reasoning of the German Institute of Public Auditors (Institut der Wirtschaftsprüfer in Deutschland e.V.) for blocking PCOAB inspections.

...the German legal system differs so significantly from that of the U.S., that implementation in Germany of certain provisions of the Sarbanes-Oxley Act, in particular, numerous aspects of the proposed rules relating to inspection, investigation and adjudications would be legally impossible and implementation of others would place extremely onerous burdens on German public accounting firms.

In Germany the auditing profession is subject to professional confidentiality obligations set forth in the legislation governing the profession and audits of financial statements. This legislations prevents our members from providing the PCAOB, as a third party, access to any or all facts and circumstances with which they are entrusted or of which they become aware during the course of their professional work. The German Penal Code makes undue disclosure by an accountant a criminal offence (§203 Strafgesetzbuch). Furthermore, the contract between a public accountant and the client carries an implied duty of confidentiality. (Source: IDW Letter to PCAOB, August 18, 2003)

As we can see, the U.S. legal environment differs greatly from that in Germany, and certainly even more from the Chinese system. But we can safely assume that oversight, regulation and professional standards for European CPA firms - PCAOB inspected or not - follow more closely the outline of U.S. standards (supporting the objectives of the Sarbanes-Oxley Act), than what we find now in China. Chinese regulators have shown no interest in reports that are not used in China and that have been prepared under US GAAP (Paul Gillis, November 14, 2010). Without independent inspections and with very loose regulations by local authorities, the right choice of auditors is of crucial importance for U.S.-listed Chinese stocks when it comes to credibility and investor confidence. The engagement of an internationally operating CPA firm, with an excellent reputation and a strong presence in China, is a necessity for every foreign-listed Chinese company that has reached a certain level of maturity.

In our safety/risk model, the choice and history of auditors has the highest weight. It is our belief that any U.S.-listed Chinese company with a market capitalization higher than $100 million should be in the process of upgrading their auditor to at least a Top10-ranked firm. With a market capitalization above $200 million, a top ten firm should be used, preferably one of the Big Four. Such an upgrade might double annual audit fees, but the value that is created for the company and its shareholders should be significantly higher. We believe that senior management of every single U.S.-listed company is very well aware of this fact, and stubbornness or refusal to proceed with an auditor upgrade leaves the investor with two damaging questions:

1. Is the company afraid that a tier one auditor would ask too many questions? Revealing unplesant details that better stay hidden? Does see company see a risk that a better auditor might not sign off on the prepared financial statements?

2. Has the company tried to hire a tier one CPA firm, but got rejected as a client? Did the company fail to pass a Big Four's due diligence test? Lack of quality internal controls, inadequate documentation, or insufficient or badly trained personell? Or worse?

The Big Four firms are Deloitte, Ernst & Young, KMPG, and PricewaterhouseCoopers. Their PCAOB-registered Chinese member firms are Deloitte Touche Tohmatsu, Ernst & Young Da Hua, Ernst & Young Hua Ming, KMPG, KPMG Huazhen, and PricewaterhouseCoopers Zhong Tian. All four do additionally have a separate Hong Kong member firm.

For all other auditors, that are not included in the Top Ten, we see the biggest risks with two groups of firms:

Small and widely unknown Chinese or Hong Kong firms. They are usually not inspected by U.S. or international oversight authorities, and Chinese regulators do not show much interest in their work for non domestically-listed companies. For all we know, they might do a most excellent job as auditors, or they might just sign off on anything their clients present to them. There is no reasonable assurance of the quality of their audit work for an independent international investor, without having insider knowledge about the audit plan and thoroughness of the work and procedures.

Small U.S.-based auditors without any, or just a very limited presence in China. Small firms with just a few partners and limited professional staff, often don't even have the resources to do a proper audit in China. They might fly over some people from California for a week, or even solely rely on third-party work peformed by sub-contracted Chinese accountants, then signing off on those reports.

A company's independent auditor is responsible for reconciling U.S. filings with Chinese tax filings. With each U.S. GAAP audit, the auditor must consider the appropriateness of a company's Chinese taxes filed and paid. Severe discrepancies between U.S. GAAP reported income and PRC reported income and tax should be immediately apparent to a good and responsible auditor, particularly those with extensive experience in China. Risks are significantly higher with small and understaffed CPA firms, with either just limited experience in China or limited U.S. GAAP experience (sub-contracted Chinese accountants).

This model is meant to provide reasonable safety, nothing ever can provide you absolute safety unless you are a senior executive and know all the details first hand. There will always be a Lehman Brothers among the biggest banks, or a world class criminal scheme like Madoff's. You can't expect more than reasonable safety in anything related to the stock market.

You could of course decide that after Satyam you wouldn't touch any other Indian stock, or take WorldCom, Enron and their respective industries that you could decide to avoid. Chinese small caps are much riskier than most other groups of publicly traded companies. For reasons well known to most investors. The model is designed to help assessing those risks for investors who do not want to stay away from the group altogether. It can not do more than that, and I won't tell you anything else in the future.

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